Tax for the self employed, explained

Tax is complicated enough for an individual in full-time employment, but for the self employed, the system becomes even more demanding. Ahead of the January 31st deadline, we take a deeper look at how to explain tax for the self employed.

“Tax”, according to the HMRC, “doesn’t have to be taxing”, but for entrepreneurs who decide to strike out on their own, it’s still regarded by many as one of the biggest minefields they need to negotiate.

Part of the reason is that tax legislation doesn’t sit still for long. Until the 2014 Budget, the choice facing most small businesses was relatively simple – opt to be either a sole trader or a limited company.

Originally the choice SME owners faced was one of responsibility – with sole traders, the law doesn’t distinguish between the owner and the business; whereas under a limited company set-up, the company is its own legal entity, limiting how much the owner is liable if the business runs into trouble. However, it’s long been acknowledged that it’s the tax difference that has really mattered most: sole traders are taxed at income tax levels (typically around 30%), while limited companies are taxed at corporation tax levels (currently 20% to year ending March 31).

For limited companies, owners could be super tax-efficient by paying corporation tax on their profit, paying themselves a very minimal official wage (that attracts little income tax) and then paying themselves a top-up in the form of a dividend – which is not taxed.

But because government has been driving down corporation tax to make UK public limited companies (plc) more competitive (it will fall to 18% by 2020), George Osborne was forced into coming up with solutions to recover so-called lost tax income from limited company owners by announcing the ‘dividend tax’. From April 2016, the notional 10% tax credit on dividends (which meant the 10% tax levied on basic rate tax payers was reduced to zero) will be abolished. Henceforth, only the first £5,000 of dividend income will be tax-free. Income above that will be taxed at 7.5% for basic-rate taxpayers and 32.5% for higher-rate taxpayers.

This change needs to be noted by business owners, but it doesn’t have to be complicated. Dividend income still forms part of people’s personal allowance (i.e. their first £11,000 in income), meaning that by adding the £5,000 allowance on top of that, they won’t pay tax until their dividend goes above £16,000.

But, as ever, there will be losers and it means the choice facing businesses is now largely a mathematical one: higher rate taxpayers can receive £21,667 in dividend payments each year before they start paying more tax in the new system than under the old. Additional-rate taxpayers will be better off under the new regime as long as their dividend income does not exceed £25,401.

Those earning more than this could chose to offset any extra tax by paying additional dividends into an ISA or by making a pension contribution. By paying a £3,600 pension contribution, owners can effectively extend their basic rate tax band from £43,000 to £46,600 (2016/17 tax year).

Those with small numbers of employees can take comfort from the Chancellor’s Autumn Statement U-turn on cutting tax-credits, meaning lower-paid employees will continue to have their wages topped up by government rather than SMEs paying more NI. However, small business owners – including the self employed – will still need to work out whether to start charging VAT for their services. They only have to do so if they earn more than £81,000 pa, but they can do it below this threshold. Some believe it adds prestige and VAT can be claimed back on items they need to buy for their business. However, the downside is that they will appear to be 20% more expensive.

Is tax simple? Not always. But some things never change: it’s just a case of knowing what applies to you and then doing your sums!

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.